We previously reported (seehere and here) on the Ninth Circuit’s consideration of an appeal involving the mortgage interest deduction – specifically, whether the statutory limits on that deduction apply on a per-taxpayer or per-residence basis. The unmarried taxpayers here (Charles Sophy and Bruce Voss) argued that they were each entitled to take a deduction up to the $1.1 million limit for the residence that they co-owned, and thereby receive double the tax benefit that a similarly situated married couple would receive, but the Tax Court disagreed. The briefing in this case was completed in April 2013, but the Ninth Circuit did not schedule oral argument until almost two years later. The court has finally issued its decision, reversing the Tax Court by a 2-1 vote. (Although we have referred to the case as Sophy based on the Tax Court’s caption, the Ninth Circuit opinion reverses the order of the two taxpayers in its caption, and therefore the case may come to be referred to as Voss in the future.)

The majority opinion (authored by Judge Bybee and joined by 8th Circuit Senior Judge Melloy, sitting by designation) recognized that neither the statute nor the regulations directly address this question and then engaged in a detailed textual analysis of various provisions of Code section 163. The majority found the strongest evidence of the correct answer in the statute’s treatment of married taxpayers who file separately. In order to put them in the same position as married taxpayers who file jointly, the statute provides in a parenthetical that married taxpayers filing separately are each entitled to a $550,000 deduction. Because that approach reflects a per-taxpayer rather than per-residence treatment, the majority concluded that the same per-taxpayer approach should be applied to unmarried taxpayers, even though it arguably gives them a windfall double deduction.

The majority rejected the Tax Court’s argument that other provisions of Code section 163 reveal a “focus” on the residence, and it also rejected the Tax Court’s explanation that the approach to married-filing-separately taxpayers was meant to address only the proper allocation of a deduction that is already limited to $1.1 million per residence. Finally, the majority acknowledged that its holding results in a “marriage penalty,” but surmised that “Congress may very well have good reasons for allowing that result” and added that, even if Congress didn’t, the court was bound by the text of a statute that singles out married taxpayers (who file separately) for specific treatment that is not explicitly provided for unmarried co-owners.

Judge Ikuta dissented, arguing primarily that the court should defer to the IRS’s administrative interpretation of the statute set forth in a 2009 Chief Counsel Advice memorandum. She maintained that this informal guidance is entitled to “Skidmore deference,” which the Supreme Court has described as a measure of deference equivalent to the interpretation’s “power to persuade.” The majority found that this level of deference was negligible because the CCA contained only a fairly cursory analysis of the statute, which carried little power to persuade. Judge Ikuta reasoned, however, that the CCA is “more persuasive” than the taxpayer’s interpretation, “which would result in a windfall to unmarried taxpayers.” As to the majority opinion, Judge Ikuta characterized as “the thinnest of reeds” its reliance on the treatment of married taxpayers filing separately.

The government has until November 3 to seek certiorari, but there is no reason to expect that the government would seriously consider seeking Supreme Court review in this case.

As a follow-up to our posts on the Goosen case regarding sourcing of a golfer’s income from sponsors (seehere), we provide this update on the case involving golfer Sergio Garcia. While they were not technically related cases, the significant overlap in issues and facts—not to mention witness testimony—meant that the outcome in Goosen partially determined the outcome in Garcia.

Both cases involved the character of the golfers’ endorsement income. Coincidentally, the golfers each had an endorsement contract with the same brand—TaylorMade. The golfers both argued that the lion’s share of the endorsement income was royalty income (i.e., paid for the use of the golfer’s name and likeness) and not personal services income (which is typically subject to a higher tax rate than royalties because of tax treaties).

Garcia had sold the rights to his image to a Swiss corporation (of which Garcia owned 99.5%) that in turn assigned the rights to a Delaware LLC (of which Garcia owned 99.8%). Garcia’s amended endorsement agreement assigned 85% of the contract payments to the LLC as payments for the use of his image rights. So Garcia argued that at least 85% of the endorsement payments were royalty income by virtue of the terms of the endorsement agreement. The Service originally argued that none of endorsement payments were royalty income and that all of the payments were for personal services. But the Service later tempered its position and argued that the “vast majority” of payments were for personal services.

Thanks to some testimony by the TaylorMade CEO that undermined the allocation in the agreement, the Tax Court declined to follow the 85/15 allocation in the amended endorsement agreement. But the Tax Court also rejected the Service’s argument that the “vast majority” of payments were for personal services. And the Tax Court determined that a 50/50 split was unwarranted.

In rejecting the 50/50 split, the Court tied the outcome in Garcia directly to the outcome in Goosen. As we wrote before, the Court opted for a 50/50 split between royalties and personal services for Goosen’s endorsement income. But expert testimony in Goosen contrasted Goosen’s endorsement income with Garcia’s. The expert in Goosen (Jim Baugh, formerly of Wilson Sporting Goods) had testified that, while Goosen had better on-course results than Garcia, Garcia had a bigger endorsement deal because of Garcia’s “flash, looks and maverick personality.” Consequently, the Court found that Garcia’s endorsement agreement “was more heavily weighted toward image rights than Mr. Goosen’s” and decided on a royalty/personal services split of 65/35.

The Tax Court also rejected the Service’s argument that Garcia’s royalty income was taxable in the U.S. under the U.S.-Swiss treaty. Perhaps the IRS will appeal that legal issue. Will Garcia appeal? The Tax Court’s decision is a victory for Garcia relative to the outcome in Goosen. On the other hand, if Garcia’s brand hinges on his “maverick personality,” then perhaps the “maverick” thing to do is to roll the dice with an appeal. Decision has not yet been entered under Rule 155, so we will wait to see whether there is an appeal.

The Government has filed its brief in the taxpayers’ appeal to the Ninth Circuit of the Tax Court’s decision that the mortgage interest deduction applies on a per residence rather than per taxpayer basis. See our previous coverage here. Section 163(h)(3) limits deductible mortgage interest to “acquisition indebtedness” of $1,000,000 and “home equity indebtedness” of $100,000. With their Beverly Hills home and Rancho Mirage secondary residence, domestic partners Bruce Voss and Charles Sophy had considerably more indebtedness, and argued that, together, they should be able to deduct interest paid on up to $2.2 million of acquisition and home equity indebtedness because the limitations should be applied on a per taxpayer rather than per residence basis. In its opposition brief, the Government argues that the statutory text supports a per residence limitation. The statute refers to acquisition or home equity indebtedness “with respect to any qualified residence of the taxpayer.” According to the Government, “the word ‘indebtedness’ is used in direct relation to the ‘residence,’ and the word ‘taxpayer’ is used only in connection with the ‘residence,’ not with the ‘indebtedness.’” The Government also finds support for its position in the Code’s definition of “acquisition indebtedness” as indebtedness incurred in acquiring a residence, not as indebtedness secured in acquiring a taxpayer’s portion of a residence. Turning to policy arguments, the Government observes that the taxpayers’ interpretation would create an unintended marriage penalty. Married taxpayers filing separately are limited to acquisition and home equity indebtedness of one-half the otherwise allowable amount, or $500,000 and $50,000 respectively.

In their reply brief, the taxpayers argue that the general rule of section 163(a) (“There shall be allowed as a deduction all interest paid within the taxable year on indebtedness.”) must be read as referring to the taxpayer’s indebtedness. This “clearly implied” meaning, they argue, should inform the interpretation of the mortgage interest deduction provisions. The taxpayers also seek support for their interpretation in references in the legislative history to the indebtedness on the qualified residence as being “the taxpayer’s debt.” With respect to the Government’s marriage penalty argument, the taxpayers note that the Code often treats married couples as a single taxpayer, and married couples enjoy many benefits from that treatment, benefits that are not enjoyed by domestic partners. The reply brief concludes with the following: “Once Congress made the decision to treat spouses as a single taxpayer, the resulting benefits and burdens must be respected equally. In this case, Taxpayers should not be assigned the burden (or penalty) that results from the Tax Court’s convoluted reading of section 163(h)(3) which treats Taxpayers as a married couple, when they receive none of the marriage benefits.”

The Bergmanns participated in a listed transaction promoted by KPMG, known as the Short Option Strategy. When the Bergmanns filed their amended return in March 2004, the IRS had already served KPMG with summonses targeted at KMPG’s promotion of the Short Option Strategy. As discussed in an earlier post, the Tax Court held that the Bergmanns failed to timely file a qualified amended return and thus were subject to the 20-percent accuracy related penalty. Under the regulations in effect when the taxpayers filed their return, the time for filing a qualified amended return terminated when “any person described in § 6700(a) (relating to the penalty for promoting abusive tax shelters) is first contacted by the Internal Revenue Service concerning an examination of an activity described in § 6700(a) with respect to which the taxpayer claimed any benefit on the return . . . .” Treas. Reg. § 1.6664-2(c)(3)(ii). The Tax Court rejected the Bergmanns’ argument that the promoter provision of the qualified amended return regulations required the IRS to establish that KPMG was liable for the § 6700 promoter penalty.

On appeal, the Bergmanns’ principal argument is that the Tax Court erroneously applied the current qualified amended return regulation rather than the regulation in effect when the amended return was filed. The current regulation, Treas. Reg. § 1.6664-2(c)(3)(i)(B), which applies to amended returns filed on or after March 2, 2005, treats as a terminating event the “date any person is first contacted by the IRS concerning an examination of that person under § 6700 . . . for an activity with respect to which the taxpayer claimed any benefit on the return,” rather than the date “any person described in § 6700(a)” is contacted. The Bergmanns acknowledge that their amended return would be untimely under the current regulations.

The Bergmanns argue that the Tax Court must have relied on the current regulations because its paraphrase of the regulation tracks the language of current regulation. In its brief, the Government argues that it was clear from both the post-trial briefing and the Tax Court’s decision that the Tax Court was fully aware of which regulation was controlling and in fact cited the correct version. The Government then argues that the Tax Court correctly interpreted the operative regulation. Because the terminating event is the “first contact” with the promoter, the timing should not turn on the ultimate results of the § 6700 investigation of the promoter. And, the Government argues, any ambiguity in the regulations should be resolved by deference to the agency’s interpretation of the regulation. The Treasury Decision accompanying the amended version of the promoter provision explained that the new language was intended to “clarify the existing rules,” and, specifically, that the language “clarifies that the period for filing a qualified amended return terminates on the date the IRS first contacts a person concerning an examination under section 6700, regardless of whether the IRS ultimately establishes that such person violated section 6700.” T.D. 9186, 2005-1 C.B. at 791-82. The taxpayers’ reply brief largely ignores the Government’s arguments. Oral argument has not yet been scheduled.

Last spring, the Tax Court held in Sophy v. Commissioner,that the limitations on indebtedness for the mortgage interest deduction are applied on a per residence rather than per taxpayer basis. The taxpayers appealed to the Ninth Circuit (Nos. 12-73257 and 12-73261), and filed their opening brief on January 30. The government’s response is due in March.

Under I.R.C. § 163(h)(3), taxpayers are allowed to deduct “qualified residence interest,” which includes interest paid or accrued on acquisition indebtedness with respect to any qualified residence of the taxpayer, or home equity indebtedness with respect to any qualified residence of the taxpayer. For purposes of the deduction, acquisition indebtedness is capped at $1 million and home equity indebtedness is capped at $100,000, for a total indebtedness limit of $1.1 million on up to two residences. The taxpayers, an unmarried couple registered as domestic partners with the State of California, had approximately $2.7 million of indebtedness associated with their primary residence in Beverly Hills and secondary residence in Rancho Mirage, California. They argued that, together, they should be able to deduct interest paid on up to $2.2 million of indebtedness, or $1.1 million each. The Tax Court rejected this position. Parsing the language of the statute, the Tax Court noted repeated references to “residence” in the provisions on the indebtedness limitations and concluded that the limitations are “residence focused rather than taxpayer focused.” The Tax Court also found support for treating the $1.1 million limitation as a per residence rather than per taxpayer limitation in the subsection of § 163(h) that provides that married taxpayers who file separate returns are limited to half of the otherwise allowable amount of indebtedness, and in the general rule that married couples filing jointly are subject to the $1.1 million limitation.

On appeal, the taxpayers argue that § 163(h) should be construed consistently with I.R.C. § 121, which limits the exclusion of gain from the sale of a taxpayer’s “principal residence” to $250,000. Under the regulations, the limitation is applied on a per taxpayer, not per residence basis. Section 163(h) defines “principal residence” with reference to § 121. The taxpayers also argue there is no reason to treat non-married couples the same as married couples for purposes of § 163(h) because differential treatment “is consistent with various provisions of the Code where there is a different result for similarly situated taxpayers based on filing status.”

About Miller & Chevalier’s Tax Appellate Blog

Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.